Imperatives for the Private Equity CEO

After languishing in the aftermath of the global credit crisis, private equity activity is once again on the rise. As of October, buyout firms had made $173 billion worth of deals this year, a level representing a bump of about 95 percent over last year, according to Thomson Reuters. And, with debt cheap and private equity firms flush with cash, deal-making momentum should continue to build—as will the need for seasoned leaders able to steer portfolio companies to growth.

But while the corporate world teems with would-be portfolio company CEOs, finding one who can engage employees, make operational improvements and ultimately deliver value is no easy feat, agreed private equity CEOs gathered for a Chief Executive roundtable discussion held in partnership with Fifth Street Finance and Rutan & Tucker, LLP. At a struggling company, the right CEO can make all the difference, asserts Len Tannenbaum, CEO of Fifth Street, who points to one of his portfolio companies, California- based Traffic Control and Safety, as an example. Near collapse when Fifth Street brought in a new CEO six months ago, the company is now stabilizing under his watch. “That crisis is evidence of the difference the right management team can make,” says Tannenbaum.

At the same time, even the most diligent of private equity companies can go through a lengthy vetting process to identify a financially savvy leader with a fantastic track record, a seemingly perfect skill set and relevant industry background, only to have him crash and burn. Just ask Michael Bruno, managing partner of Stonebridge Partners. “We’ve had some CEOs with the greatest resumes you’ve ever seen who failed miserably,” he reports.

Why the disconnect? In brief, the challenges and opportunities inherent in running a portfolio company, and the high cost of failure, make identifying and attracting an appropriate leader particularly tricky. Sometimes the issue is all too clear—at least in hindsight. For example, a leader who thrived in a large public company environment often struggles to replicate that success in a more entrepreneurial company with limited resources and less structure.

Successful Support

As important as it is to choose the right CEO, providing the tools and support essential to success is just as vital. Roundtable participants identified five steps toward paving the way for a new CEO’s success.

Provide Peer Support: At Longroad Asset Management, the CEOs and CFOs of all of the firm’s portfolio companies dial into a conference call to chat about pressing issues. “While every business is different,” notes Richard Latto, “they have certain underlying drivers and tremendous synergies, so we get good results from that cross pollination.”

Clear the Path. Even the best general can’t skirt mines without a map. Veteran portfolio company CEO Greg Grosch urges firms to get a field report from middle management before dropping a new CEO into their ranks. “Find out if there are any disruptions there,” he says. “For example, did the owner of the company make promises that he won’t be delivering on now? If so, they’ll be very disgruntled and it will take time to get that monkey off your back.”

Align Your Expectations. A candid conversation early on can prevent conflicts later. “The CEO needs to understand your game plan—that you’re going to be there for three to seven years or whatever and this is what he can expect from you and this is what you expect from him,” says Grosch. “If that’s done and you picked the right guy and the right team, there shouldn’t be a lot of conflict.”

Jettison Lurking Founder-CEOs. Even a well-intentioned founding CEO can jeopardize success. “Rarely do they think, ‘Oh, the private equity guys are doing a much better job than I did,’ ” notes Michael Bruno. “Instead they whisper in the background, second-guessing decisions.”

Let Your CEO be a CEO. “One of the biggest mistakes you can make is to micromanage,” warns Grosch. “When you pick the guy you’re going to go with, you need to make sure that you give him long legs so that he can run and win the race.”

In other cases, success in one industry doesn’t translate to another, notes Andrew Brickman, a partner at Baird Capital Partners, who recounts a failed attempt to install a chemicals business CEO at a distribution company. “You think, ‘Oh, he’s a great athlete and he can win anywhere,’ ” he says. “That hasn’t worked for us.”

Worse yet, a wrong call on a CEO can quickly devastate an organization. “There’s a multiplier effect when you pick someone and go in the wrong direction,” warns Richard Latto, managing director of Longroad Asset Management. “Because that person hires three people, those three each hire three more, who each hire three more and so on until you’ve hired 81 bad people within 18 months.”

So what does work? How can private equity firms suss out the business leader able to step seamlessly into a portfolio company, implement operational improvements and lead it to growth? Stonebridge Partners’ secret sauce in CEO selection is to engage leaders with a specific set of experiences. “Typically they’ve worked in a private business as well as with a larger company and have already done a few private equity deals,” says Bruno, noting that the high level of debt that portfolio companies tend to carry requires more vigilant cash-flow management. “CEOs who haven’t had much debt don’t know how to oversee a private equity transaction.”

The Deep Dive

Many private equity firms find the issue critical enough to warrant a rigorous assessment process. At Spire Capital, a psychologist is brought in to conduct two-day, 16-hour evaluation sessions with prospective CEOs. “We get a deep psychological profile as well as feedback on a list of 20 areas that we identify for them as sensitive issues,” says Richard Patterson, co-founder of the firm. “We’ve found they’re 80 percent accurate in identifying problems.”

Calvert Street Capital Partners uses a similar process to vet not only CEOs, but every professional in the firm. “It reveals any red flags in a person’s personality, but it also helps identify potential issues, such as a flaw in a person’s ability to communicate, that we need to know about one another in order to be good partners,” explains Joshua Hall, a senior partner at the firm. Beyond helping a private equity firm choose a CEO, the process can highlight areas where that individual might need support.

Because Baird Capital places a premium on the ability of a prospective CEO to cultivate leaders, its evaluation process involves an in-depth look at members of a CEO’s former management team. “We dive into their backgrounds,” says Brickman. “We look at whether the people who worked for him went on to succeed because then chances are he can regenerate that team again.”

For Serent Capital, the importance of strong portfolio company leadership led the firm to designate one partner who focuses solely on recruiting, retaining and cultivating CEOs. Because most of the company’s acquisitions entail a CEO transition, the partner attends any serious meeting held with the leaders of prospective acquisitions and performs a full diagnostic on its management team. “We buy companies in the $20 million-to-$40 million revenue range, so who’s in that slot matters a lot,” says Ryan Kerrigan, the firm’s managing director. He emphasizes that the partner in question is both a former CEO and an executive-search-firm veteran. “We built that into the design of our firm. It’s that critical.”

Transition Time?

While replacing the sitting CEO isn’t a prerequisite for private equity firms, most roundtable participants report that significant management team changeouts are the norm rather than the exception. “I’d say in almost all of the companies we get involved in, some seats are going to change,” reports Brickman. “We’re going to reorganize the bus and maybe the CEO seat as well.”

More often than not, private equity firms go into at least half of deals knowing that a new CEO is part of the plan. And for good reason, says Greg Grosch, a veteran entrepreneur who recently stepped into the leadership role at Traffic Control and Safety, one of Fifth Street’s portfolio companies. Reflecting on his own struggle transitioning White Cap Industries—a company he founded earlier in his career—to new ownership, Grosch notes that founding CEOs often inadvertently become a “disruptive influence.” “I was too emotionally attached to my business to really look objectively at the game,” he recalls. “It was my way or the highway.”

“Sometimes you need to distance that guy as far as you can from the company,” adds Grosch. “Because he’s the bad apple that can spoil the whole barrel.”

Family companies still led by the founding CEO can be particularly tricky, in part because succession planning and personal relationships are so intertwined. “Often when we’re buying a nice family business where the patriarch is still involved, he’s good and we don’t want to ruin the legacy that got the company where it is,” says Scott Warren, a managing partner at Milestone Partners. “But we have to start planning for the future. It’s an intensely personal topic for the CEO and that leads to procrastination. So we struggle with getting the high-powered family business CEO on board with [succession planning].”

Acting quickly is the most effective way to ease the process and minimize the transition fallout, asserts Joshua Hall, a senior partner at Calvert Street Capital Partners, who describes bringing a new CEO into a small companies as “a horrifying experience.”

“But we’ve done it a lot, and we’ll keep doing it,” he adds. “And the hardest thing is making the decision as quickly as you can. Because we’ve never changed a CEO and afterward thought, ‘You know, we should have held off on that,’ ” he says. “It’s always something you should have done earlier.”

Circumstantial Evidence

Of course, what a private equity firm looks for in a CEO has to be tailored to the situation. “We believe there are two types of CEOs—peacetime and wartime generals,” says Latto, who says his firm generally buys “horribly run” companies and changes out the management team. “For example, it might be a poorly run, highly leveraged family business where you need to remove not only the CEO, but his two brothers, three kids and countless holding company relationships they had.”

Longroad Asset Management generally sheds the top layer of management, brings in a CEO and seeks to promote some of the competent people in the layer below to balance out the new leader’s skills set. “If your CEO is a tremendous salesperson, you want a strong operator and a very good finance person,” explains Latto, who seeks a team capable of covering the three key management areas: sales, operations and finance. “If he’s good financially, you need sales and operations.”

With troubled firms, often a special ist is in order. For example, a turnaround of the home decor company Design Within Reach demanded a CEO who could rally employees around dramatic change, recounts William Sweedler, cofounder and partner of Tengram Capital Partners. “We recognized that it was going to be the ultimate turnaround, so we had to find the CEO who could not only change the culture, but come in and take the surviving employees and motivate them and lead them in a new direction. Our search focused specifically on that.”

“Not every CEO is right for every role,” agrees Sam Levine, managing director and co-head of Eos Partners. “There are a lot of middle-market companies who don’t have great back office functional controls; they need a CEO who can help them professionalize to gain scalability and get to the next level. You have to look for what the situation calls for.”

At the end of the day, the portfolio company CEO and his or her working relationship with the private equity firm will play a large role in determining the portfolio company’s ultimate success or failure. “You really need to do your homework,” says Greg Grosch, founder of White Cap Industries. “It’s a puzzle and all the pieces need to be there. Missing any one can be disastrous.”

Who’s Who

David Belluck is general partner atRiverside Partners, a private equity firmin Boston that specializes in investmentsin middle-market technology andhealthcare firms.

Andrew Brickman is a partner at BairdCapital Partners, a Chicago-based lowermiddle-market private equity businessspecializing in business services, healthcareand manufactured products.

Richard H. Patterson is co-founderand a partner at Spire Capital, a privateequity firm specializing in the media,communications, information servicesand business services. It has offices inNew York and West Conshohocken,Pennsylvania

Daniel Stein is president & CEO ofDimensional Associates, a company withinvestments in small and middle-marketdigital media companies.